Cromwell Group (ASX: CMW), DEXUS Property Group (ASX: DXS) and Investa Office Fund (ASX: IOF) are real estate investment trusts (REITs) specialising in office space. All three own office buildings located in the CBDs of major Australian cities.
Cromwell Group manages assets worth $10.1 billion including $5.9 billion of assets based in Europe after acquiring Valad Europe for $207 million on 31 March 2015. However most of its earnings come from rental income on its own $2.1 billion portfolio consisting of 25 properties. A total 23.3% of gross income comes from the Federal Government and a further 21.3% comes from the New South Wales and Queensland governments.
DEXUS is the biggest of the three trusts and is the largest owner of office buildings in Sydney's CBD. It has $19.1 billion of assets under management including its own portfolio of about $9.5 billion. The vast majority of its profits (89%) come from this portfolio which consists of $7.8 billion of office space and $1.7 billion of industrial buildings.
Investa owns 22 properties worth $3.2 billion, around half of which are located in Sydney. Unlike Dexus and Cromwell, Investa does not actively manage its own portfolio, nor does it manage assets on behalf of other investors. Instead, it outsources property management to an entity controlled by Morgan Stanley Real Estate Investing.
A decent investment delivers returns in excess of the risk-free rate that grow above inflation over time. Accepting a return of less than the risk-free rate can still turn out well if subsequent growth is much higher than inflation. This is essentially the premise of growth investing. Similarly, if the initial return is far higher than the risk-free rate but does not grow with inflation, this can also work out okay.
Upfront returns are dictated by prices, whereas future returns are driven by asset quality. Given all three trusts pay out most of their normalised operating profit as distributions, distribution yields serve as a good proxy for current returns. Cromwell has the best yield of 8.3%, followed by DEXUS with 5.8% and lastly Investa with 5.0%. Distributions paid by all three securities are unfranked because trusts do not pay tax on profits.
Although Cromwell has the best distribution yield there are possible reasons why it is discounted by the market. Firstly, it has the most debt relative to its equity base with a gearing ratio of 45% compared to under 30% for the other two trusts. Also, it appears to pay out more cash than it currently generates. Roughly speaking, DEXUS and Investa pay out all profit after adjustments for non-cash items and allowances for lease incentives and maintenance capital expenditure. Cromwell, on the other hand, seems to pay out its profit before maintenance capital expenditure and lease incentives are covered.
All three trusts offer decent current returns but will they beat inflation over the long-term? It sounds reasonable to assume that the cost of rent and values of centrally located office buildings will rise over time. However these factors do not necessarily translate into satisfactory investment returns.
All three trusts are paying lower distributions per security today than they were in 2008. Cromwell paid 79% of its 2008 distribution in 2015, DEXUS paid 57% and Investa paid just 45%. Perhaps we are still at the low point of the cycle but that seems unlikely since seven years have passed since the GFC and many other parts of the economy appear to have fully recovered.
Another possibility is that some returns have not been paid out in dividends but instead reinvested into assets. Net tangible assets (NTA) per unit gives an approximation for the value of a trust's property portfolio and investments less its debt and other liabilities belonging to each unit. Tracking its movement over time will show whether the trusts have indeed been holding back some funds for reinvestment or, alternatively, using them to pay down debt.
However, since 2008 NTA per unit has also fallen. Cromwell now has an NTA per unit which is 64% of 2008 levels, for DEXUS it is 63% and for Investa it is just 50%. It could be argued that asset prices in 2008 were much higher than what the assets were actually worth but even so it is hard to imagine that the effect is large enough to hide significant growth in NTA per unit over the last seven years.
Office REITs are exposed to economic cycles, generally carry lots of debt and have weak growth prospects. The best time to purchase these securities is at the nadir of a recession. If you had bought any one of these three trusts on 30 June 2009 and held to today, you would have more than doubled your money including distributions. As any investor can attest, buying at such times is much easier said than done.
